Distributions and Penalties

IRAs were designed to allow and assist individuals planning for their retirement. IRA rules were established to discourage individuals from diminishing their IRA funds prior to retirement. First, any money withdrawn from an IRA is includable in gross income in the tax year received. The exceptions to this rule are as follows:

Rollovers which are re-deposited within 60 days of constructive (actual) receipt;
Transfers from custodian to custodian;
Excess contributions removed before the tax return deadline provided that the interest attributable to the excess is also removed;
Excess amounts removed after the tax return deadline provided that total contributions for the year were $2,250 or less;
Transfers as a result of a divorce decree;
Any distribution of nondeductible IRA contributions.

Distributions from IRAs accepted before tax contributions are taxed as ordinary income and appear on Forms 1040 and 1040A. Distributions from IRAs created by nondeductible contributions are not taxed because income tax has already been paid on these amounts. At PENSCO, nondeductible contributions cannot be made to an IRA receiving deductible contributions. A separate IRA must be established. In addition, certain other rules apply. Under the distribution regulations for instance, if the individual has reached the age of 70 ½ and is subject to required minimum distributions (RMD), they may not transfer the amount of their RMD. Instead, the resigning custodian must withhold the RMD prior to transferring the holder's IRA.

Similarly, an individual may not rollover required minimum distributions. The individual must first satisfy their RMD with their current custodian before rolling over the balance to a new custodian. The rules dictating the methods for determining the minimum distribution amount are complex. However, even more important, in terms of potential tax impact on the IRA holder and their beneficiary(s) is the relationship between the distribution elections and the naming of beneficiary(s). For these reasons, PENSCO Trust has developed a new tax advisory service, where clients and brokers can obtain important counsel on these issues. Please call PENSCO Trust at (415) 274-5600 to learn more about this service.

Early Distributions Before Age 59½

Distributions prior to the date the IRA holder turns 59½ are generally subject to a 10% penalty tax. In addition, the distribution amount is taxed as ordinary income with the following exceptions (IRC Sec. 72(t)):

Death

If the IRA holder dies, the beneficiary may receive a distribution without penalty.

Disability

If an individual is disabled (and proof of a permanent disability must be provided by law (See IRC Sec. 72(m)(7)), and accepts a distribution, it will not be penalized. PENSCO Trust requires a letter from the state or public court in which the individual resides, establishing that the individual is legally disabled.

Rollover

A direct rollover, indirect rollover or transfer is unaffected.

Nondeductible Contributions

Funds withdrawn from IRAs that were nondeductible contributions are not penalized.

Substantially Equal Payments

The owner has the option to receive substantially equal periodic payments (IRC Sec. 72(t)(2)(A)(W)), under a controlled method, prior to the age 59 ½ (see below). The following rules, however, apply:

Payments must be made at least annually;
The series of payments must continue for at least 5 years unchanged or until the holder reaches the age of 59½, whichever is later;
Payments must be made over the single life expectancy of the holder or the joint life expectancy of the holder and their beneficiary;
If the series of payments, once begun, are modified in any way, the 10% penalty plus interest will apply to all prior payments retroactively.

Distributions From An IRA At Age 59½

Once an individual reaches the age 59½, they are free to take distributions without penalty. In addition, there is no limit on how much may be withdrawn from the IRA. Of course, all distribution amounts are included in the individual's gross income calculation for tax purposes.

Minimum Distributions From An IRA At Age 70½

When an individual turns 70½, the distribution rules require that they at least begin taking minimum distributions (they can take more than the minimum without penalty). If they fail to at least take the minimum, they will be subject to a 50% excess accumulation penalty on the distributed difference between what should have been (the minimum) and what was taken (IRC 4974).

An individual needs to carefully review options they have when selecting both beneficiaries and the distribution method (e.g. based on either joint or single life expectancy and either recalculation or straight line calculation), prior to analyzing a distribution election with a custodian. In general, however, the law requires that funds be taken out of an IRA beginning the year an individual turns 70 ½. Alternative approaches can be elected that can affect the minimum that must be taken each year. Choosing joint life expectancy, for example, can reduce the amount of the distribution required each year. Since those options, once elected, cannot be revoked, it is important that an individual understand the impact of any choices made. PENSCO Trust now has a service, to assist brokers and clients with these choices. Contact PENSCO Trust to learn more.

Prohibited Transactions

An IRA can lose its exemption from federal income tax if the individual establishing the IRA, or the beneficiary, engages in prohibited transactions. Prohibited transactions include any direct or indirect:

Sale, exchange or lease of any property between the IRA and a disqualified person;
Lending of money or any other extension of credit between the IRA and a disqualified person;
Furnishing of goods, services or facilities between the IRA and a disqualified person;
Transfer to or use, for the benefit of a disqualified person, of the income or assets of the IRA;
Act by a disqualified person who is a fiduciary whereby they deal with the income or assets of the IRA in their own interest or for their own account;
Receipt of any consideration for the personal account of any disqualified person who is a fiduciary or dealing with the IRA in connection with a transaction involving the income or assets of the IRA.

In general, the term disqualified person includes the individual establishing the IRA, any designated beneficiary of the IRA, and any person who is a fiduciary or who provides services to the IRA. If the IRA loses its tax exemption, the fair market value of the IRA assets must be included in the individual's gross income for the taxable year in which the loss of exemption occurs. An additional 10% tax on the amount included in the individual's gross income as a result of such loss of exemption, will be levied if the IRA is disqualified before the individual attains the age of 59 ½. If the individual pledges all or a portion of the assets of their IRA as security for a loan, that part of the IRA assets pledged will be treated as a distribution for the taxable year in which the assets are pledged, and taxed accordingly, e.g., subject to a premature distribution tax if the deemed distribution occurs prior to age 59 ½.

Additional Information

For more information concerning distributions please link to Taxes, Dollars and Sense with Retirement Plan and IRA Assets where William T. Knox IV discusses the three-year suspension of the 15% excise tax on so-called excess distributions and tax deferral issues.